Fundamentals of Banking

Vinay Dutta
Senior Professor in Finance
FORE School of Management, New Delhi
 Discussion Issue
What comes to your mind when you first hear or see
the terms/images below?

Bank Banker Banking

 What is a Bank?

Simply speaking a bank is a financial institution

/intermediary that provides financial services,
particularly taking deposits, extending credit and
providing payment (clearing and settlement) services

Generally understood as an institution that holds a

banking license

Discussion Issue

How many of you believe that the above traditional

definition of a bank make sense in the present day
context? If yes, why? If no, think and jot down the
description of a modern-day bank?
 Definition of a bank in the present day context
B Banks are highly regulated, profit - oriented financial
institutions (now liked to be addressed as financial
super-markets / financial powerhouses) in the business of
creating money, managing money and distributing money

A Accept deposits from public for making loans or investments

and provide payment services using

N Network of branches , multiple - channels ,omnichannels

and are emerging as

K Key players offering the widest range of standardized,

customized, value-added and cost –effective financial services to
cross-section of society comprising of individuals, businesses,
govt., financial and non-financial institutions, local bodies etc.
Multi Channel Versus Omni Channel Banking

Source: https://www.ibm.com/industries/banking-financial-markets/resources/omnichannel-banking-paper/
 Banker
• Person who owns a bank
• Person who works for a bank or person pursuing
banking as profession
• Some Qualities of a Good Banker: A sensible person
should deposit his money with a person of good family;
of good conduct; well-acquainted with the law,
veracious, having many relatives wealthy and
honourable. (Source: Laws of Manu by the Buhler the sacred bonus of the
East, Vol. xxv., p.286, 1866)

• Strong character is the ultimate quality of a good

banker. Why?
• Bankers deal with Other People Money (OPM-Opium)-
Opium syndrome
 Banking

Banking as per Banking Regulation Act

“Banking is accepting for the purpose of lending or

investment of deposits of money from the public repayable
on demand or otherwise and withdrawal-able by cheque,
draft, order or otherwise”

Simply speaking, banking are the operational activities of

the banks, that is, products and services offered by banks
 International Banking

International banking is just like any other banking

service, but it takes place across different nations or
internationally. To put in another way, international
banking is an arrangement of financial service by a
residential bank of one country to the residents of
another country

Example: The International Banking Unit of SBI (State

Bank of India) strives to provide high value-added
services appropriate to the specific local needs of its
globally-operating clients of business corporations,
financial institutions, governmental organizations and
public entities.
 Defining International Banking

According to the Bank for International Settlements'

Committee on the Global Financial System, international
banking is when a bank headquartered in one country extends
credit to residents of another country--- for example, when a
Canadian bank lends money to Americans.

According to Eric Philip Davis, a senior researcher at the

National Institute of Economic and Social Research in the
United Kingdom, it also includes domestic loans made in
foreign currencies, as when an American bank issues a loan to
an American resident in euros, rather than U.S. dollars. Davis
also includes deposits made to foreign banks, as when an
American keeps money in a bank in Switzerland or the
Bahamas.

Source: https://itstillworks.com/about-5526334-definition-international-banking.html
 Discussion Issues

• Direct versus Indirect Finance

• Financial intermediation and Financial disintermediation
• Costs of financial intermediation
 Direct versus Indirect Finance
Financial disintermediation Risk exposer-Direct

Financial intermediation Risk exposure-Indirect

Financial intermediation costs: Search cost, Verification cost,
Monitoring cost, Enforcement cost
 Discussion Issue

Business Model of Banking Companies

 Business Model of Banking Companies
Key Partners Key Activities Value Propositions Relationships Customer Segments

Branch Operations
Personal
Assistance

Call center Automation where

operations position
Retail and
Deposit Products Corporate
Investment (Lower Interest Customers
partners IT Operations Rates) (Depositors)

Technology
vendors
Key Resources Channels
Loan Products Retail and
Regulatory (Higher Interest Corporate
Physical and IT
Agencies Rates) Bank Branches, Customers
Infrastructure
ATMs, (Borrowers)
Call centers,
Loan Assets Internet,
Mobile Devices

Cost Structure Revenue Streams

Interest Channel Costs Interest Income Fee Income
Expenses
 Discussion Issues

• Banks are manufacturer of money. Banks have the

power to create new money
• How do banks actually create money?
• How do banks make money?
 How do banks actually create money?

• Banks create money (credit) through Fractional Reserve

Banking practice whereby banks receive deposits from
customers and must keep a fraction of these deposits as
reserve with the Central Banking Authority, in India, the
Reserve Bank of India and / or invest a proportion of
deposits in eligible government securities.

• All Commercial Banks in India must keep a proportion of

deposits in the form of Cash Reserve Ratio (CRR) and
Statutory Liquidity Ratio (SLR)
• The process of continual lending and fractional-reserve
banking leads to creation of deposits ad infinitum – at least
in theory.
• Formula for determining the amount new money created:
D=(1/RR)*New Reserves ,Where-D=New money created;
RR=Reserve ratio; and 1/RR= Money or Credit multiplier
 How do banks create money ?

Exercise on bank’s money creation mechanism

• To understand money (credit) creation mechanism and to

know the impact of slippages/leakages on money (credit)
creation,

• To understand the impact of Financial inclusion initiative of

government on money (credit) creation in the Indian
economy

• To understand the Pyramiding Effect of financial inclusion

 How do banks make money?

• Spread Business
- Maturity transformation
- Credit spread
- Liquidity premium

• Fee Business

• Investment (financial and Strategic) and Trading Business

The Many Different Roles Commercial Banks
Play in an Economy
Roles Commercial Banks Play in an Economy
 The Intermediation Role

Transforming savings received primarily from

households into credit (loans) for business firms and
others in order to make investment in new buildings,
equipment, and other goods.

Also referred as “Transformational Role”

 The Intermediary Role

Economy

Surplus Units B Deficit Units

a
• Households n • Households
k
• Businesses • Businesses
i
• Government n • Government
• Insurance Companies g

Channelising Funds
 The Intermediation Role

Economy

Surplus Units Deficit Units

B
a
Key Requirements n Key Requirements
• Safety & Security k • Time/Schedule
• Growth
i • Risk
n
• Liquidity g

Transforming Needs and Profile

The Intermediate Role
 The Intermediation Role

Delegated Monitoring Theory

Given verification costs, it is inefficient for surplus units
(depositors) to monitor / exercise control over deficit units
(borrowers) in all circumstances.

Alternatively, a financial intermediary ( a bank) can mobilize

the savings of many individuals and lend these. This
intermediary is the delegated monitor of the borrowers by
individual savers. In turn, savers do not have to monitor the
intermediary if it holds a diversified portfolio.
 The Payment Role

Carrying out payments for goods and services on behalf

of their customers (such as by issuing and clearing
checks , wiring funds, providing a conduit for electronic
payments, and dispensing currency and coin).
The Payment Role
 The Guarantor role

Standing behind their customers debts when those

customers are unable to pay (such as by issuing
letters of credit, letter of guarantee etc.)
The Guarantor Role
 The Agency Role

Acting on behalf of customers to manage and protect

their property or issue and redeem their securities
(usually provided through the bank’s trust department).
The Agency Role
 The Policy Role

Serving as a conduit for government policy in

attempting to regulate the growth of the economy
and pursue social goals
 Discussion Issues

• Value chain in banking

• In what way value chain analysis helps a bank in
gaining competitive advantage?
 Value Chain in Banking

Deficit Units Safe Bank Surplus Units

Fund Users Fund Mobilizors Fund Providers

Money is at the end Money is in the middle Money is at the start

 VALUE CHAIN IN BANKING: BANKS AS MANUFACTURES’ OF MONEY
STAGE I
MONEY IS AT THE START
INPUT STAGE:
FUNDS MOBILIZATION
SOURCES OF MONEY:
FUNDS FROM SURPLUS UNITS AND
OWNERS (BANK DEPOSITS AND BANK
CAPITAL)
•INDIVIDUALS
•BUSINESSES
•GOVERNMENT
PRINCIPAL OBJECTIVE: PROTECTION
OF DEPOSITORS MONEY
REFINING (FILTERING PROCESS) TO
STOP STASHING OF BAD MONEY INTO
BANKING SYSTEM
COSTS MONEY TO BANK IN THE FORM
OF INTEREST, DIVIDENDS
STAGE II
MONEY IS IN THE MIDDLE
STORAGE STAGE:
TRANSFORMATION OF SAVINGS INTO
INVESTMENTS AND CONSUMPTION
AND GENERATION OF CASH
RESERVES
PRODUCT DEVELOPMENT
REPACKAGING MONEY MOBILIZED AT
STAGE I, INTO FINANCIAL PRODUCTS
AND SERVICES OFFERED BY BANKS
OBJECTIVE: BUILDING EFFICIENT
AND EFFECTIVE INFRASTRUCTURE
FOR DEVELOPING, DESIGNING AND
DELIVERING VALUE ADDED
PRODUCTS AND SERVICES AT
REASONABLE COST
REFINING (FILTERING PROCESS)
INTRODUCTION AND REVISION OF
NEW PRODUCTS AND SERVICES
THROUGH THE PROCESS OF
INNOVATION AND VALUE ADDITION
COSTS MONEY TO BANK FOR
DEVELOPING, DESIGNING,
REPACKAGING AND VALUE ADDITION
STAGE III
MONEY IS AT THE END
OUTPUT STAGE:
FUNDS DEPLOYMENT
UTILIZATION OF MONEY: FUNDS TO
DEFICIT UNITS AND FUNDS
INVESTED (BANK LENDING AND BANK
INVESTMENTS)
•INDIVIDUALS
•BUSINESSES
•GOVERNMENT
PRINCIPAL OBJECTIVE: CREATION OF
GOOD QUALITY CREDIT AND
INVESTMENT PORTFOLIO
REFINING (FILTERING PROCESS) TO
REDUCE OCCURRENCE OF PROBLEM
LOANS AND BAD INVESTMENTS
BRINGS MONEY TO BANK IN THE
FORM OF INTEREST, FEE,
PROCESSING CHARGES, INVESTMENT
INCOME ETC.
 Money is at the Start

Bank Well Bank Smell

(Progressive Approach) (Detective Approach)

Glow (Grow) your Money Slow your Money

Bank Shell Bank Hell
(Secretive Approach (Manipulative Approach)

Snow your Money Blow your Money

 Money is in the Middle

People Process

Products and Services Technology

New Product Development and Approval Process in Banking

• Bright idea for a new banking product goes to new-

business committee

• Product controllers look at issues like acceptability,

pricing etc.

• Risk managers consider risk aspects of the product

• Legal and compliance folk worry about the fine print

• Finally, if a product seems to have the potential to

tarnish a bank’s brand, it is usually get passed to a
reputational committee

The new product approval process…is extremely

conservative, indeed too conservative
Source: The Economist: February 25th, 2012
 Money is at the End

Smart Borrowers Shark Borrowers

Earn Money ( Create Value ) Burn Money (Destroy Value) of

for Banks and Make Banks Banks and Shake Banks
In what way understanding value chain helps a bank in
gaining competitive advantage

Value chain analysis helps to identify the Bank’s

present competitive advantages and that of its main
rivals, and those that must be developed in order to
reach the desired competitive position.
Value chain leads to a reconfiguration or recombination
of value chain activities that creates entry barriers for
complete or superior value for customers and earns a
sustainable competitive advantage.